A. Field of the Invention
This invention generally relates to methods for assisting in the determination of an optimal investment plan and, more particularly, to a method for selecting a rate of return on a nonperforming loan that minimizes the investor's loss potential.
B. Description of the Related Art
Maximizing the rate of return on investment dollars is the goal of all investors. Banks and similar institutions in the real estate business maximize their return realizable on loans by, for example, lending money to customers to purchase property and charging interest for the loan at a rate above their borrowing cost. The loan instrument is often referred to as a promissory note that specifies a principal amount borrowed from the lender and an interest rate, and is secured by a mortgage or deed of trust on the property. The lender's rate of return corresponds to the interest rate.
Promissory notes typically require the borrower to make periodic (often monthly) payments to the lender. Each payment usually includes a portion of the principal and interest. Generally speaking, the borrower completes her loan obligation by making a lump sum payment before the end of the period to satisfy the loan.
But not all borrowers can consistently make loan payments. Due to events often out of their control, for example, unexpected medical expenses or a layoff, borrowers sometimes stop making payments. Sometimes they stop making payments for only a short period of time and sometimes they stop making payments altogether. For these nonperforming loans, the lender has a number of options, each of which provides the lender with a different rate of return. Although all of the options are viewed as unattractive when compared to the lender's originally expected rate of return on a loan, the investor's objective in selecting an option is to choose one that maximizes the rate of return and minimize the loss potential.
One option is to foreclose on the property. The foreclosure process is a legal proceeding by which the lender will ultimately obtain title to the property. Invariably, the lender then sells the property. The cost of a foreclosure and holding the property until it is sold increases the lender's overall investment in the property. Unless the sale price for the property is substantially higher than the original value, the increased investment due to the foreclosure may reduce the lender's rate of return on the loan. The difficulties and contingencies of the foreclosure make it an unfavorable approach for dealing with certain nonperforming loans.
Another option is to allow the borrower to sell the property and pay off the loan. Although this option may seem appealing because it avoids dealing with the costly foreclosure procedure, selecting this option may give the lender less than the outstanding amount owed on the loan, unless the borrower is able to pay the difference between the lower sale price and the outstanding amount on the loan. When the lender's proceeds from the sale is less than the full amount of the loan, this is called a short payoff. A short payoff reduces the lender's rate of return on the loan, making the second option also unattractive to the lender for dealing with certain nonperforming loans.
A third option, which also avoids a costly foreclosure, would be for the borrower to simply sign over the deed for the property to the lender. The lender thus accepts a deed-in-lieu of foreclosure. Like the first option, this one burdens the lender with holding the property for a period of time and selling it, and, like the second option, the lender may have to sell the property for less than its market value or the outstanding amount of the loan. For at least these reasons, this option is also unattractive to the lender for dealing with certain nonperforming loans.
The lender's fourth option is to recognize the loan as a complete loss, writing off the principal. This option may only be appropriate when the anticipated cost associated with alternatives such as the foreclosure option (payoff of a superior lien, for example) exceed anticipated revenues from a sale of the property. For obvious reasons, this option has the lowest rate of return for the lender, making it the least attractive option for dealing with nonperforming loans.
A fifth option is to modify the conditions of the loan. This may mean decreasing the interest rate for a period of time, capitalizing past due payments into the principal amount of the loan, or making another type of modification. This allows the lender to obtain a rate of return that may approach its expected rate of return for the loan, making it a more favorable approach for dealing with certain nonperforming loans.
A sixth option is to allow an assumption of the loan by a third party who would assume responsibility for loan payments that the borrower can no longer satisfy.
A simplification of the fifth option has the lender arrange a repayment plan whereby the borrower repays a percentage of the past due payments each month in addition to the regular payment. This option is appropriate under limited circumstances, i.e., primarily when the borrower's financial information indicates either funds on hand or expected income sufficient to satisfy both primary payments on the existing loan and additional payments. This repayment plan may give the lender a rate of return higher than any other option, which makes it perhaps the most favorable approach for dealing with certain nonperforming loans.
With so many options, each with its own advantages and disadvantages, and related variables, lenders find it difficult to determine the best option for a particular situation. Historically, lenders have examined each option and tried to implement the one that seemed most viable. Lenders have heretofore been unable to evaluate the acceptability of the different options using a quantitative analysis and comparison.
It is therefore desirable to seek techniques that can provide lenders with a scheme for applying selection criteria in a consistent manner to better inform lenders considering options for nonperforming loans. The scheme should also help lenders select the best option for each case, considering the borrower's financial condition and any hardships that caused the lender to categorize the loan as a nonperforming one.